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The Worst Mistake You Can Make

Fifty-six percent of eligible employees participated in defined-contribution plans in 2006, according to a Fidelity Investments survey reported in The Wall Street Journal. That figure is down a bit from the year before, when 56.9% participated.

That means nearly half of eligible employees did not participate.

Big mistake -- considering that 39% of Americans age 55 and older have less than $25,000 saved for retirement.

Unless you're (a) planning on winning the lottery or (b) inheriting millions, snubbing your company's 401(k) plan is the worst mistake you can make for your retirement.

So what's a Fool to do?

Get in the game Fool retirement guru and Rule Your Retirement advisor Robert Brokamp has said that 401(k) plans with an employer match should be the first place to put money away for the long term -- you don't want to turn away free money, after all.

That's even more important for today's worker facing an uncertain Social Security benefit and an increasingly nonexistent, vanishing, or underfunded traditional pension plan.

Free money's not the only reason to fund your 401(k). Even without an employer match, employee contribution plans have tax benefits. Money contributed to an employer plan is not included in your income, and taxes are not due until retirement. Plus, the amount you decide to contribute will be transferred directly from your paycheck to your account, so you won't have to go through the process of parting with your cash every month.

I did call ... earlier ... or was it later? Most important, the sooner you contribute to your company's plan, the more you can take advantage of compounding interest. For example, if you start contributing $250 a month to a 401(k) at age 20, and match the market's historical annualized return of 10%, your nest egg will reach $1.4 million by the time you're 60.

Years

Results

10

$53,000

20

$189,000

30

$542,000

40

$1.4 million

Source: MoneyChimp calculator.

That $1.4 million nest egg assumes no employer match. Include an employer match of 50%, and your retirement account rises to $2.2 million!

Obviously, the earlier you start, the better. But if, say, you're 40 years old and have a standing start of $0, the time to start is now -- letting that money compound for 25 years will have a huge effect on your retirement nest egg.

So how do you go about matching the market's historical return of 10%?

Diversify
One thing the Fidelity survey indicated was that many 401(k) participants are inadequately diversified -- often holding more than 20% of their portfolio in their employer's stock! No single stock -- including your own company's -- should make up more than 10% of your portfolio.

What would a well-diversified portfolio look like? For an aggressive investor -- one who is decades away from retirement -- Robert recommends a model portfolio made up almost entirely of equities, with only a small allocation to bonds. Roughly 50% would be devoted to large-cap blue chips such as General Electric (NYSE: GE) , IBM (NYSE: IBM) , and Cisco (Nasdaq: CSCO) , which generally come with less volatility and increasing dividends.

Small-cap stocks such as Chico's (NYSE: CHS) , Pacific Sunwear (Nasdaq: PSUN) , and Panera (Nasdaq: PNRA) are capitalized at $2 billion or less, and although they can be risky, they have a lot of potential. The aggressive portfolio advises a 15% allocation to small caps, with another 10% devoted to stocks headquartered outside the United States. A good play for that portion is the Vanguard Total International Stock Index Fund (VGTSX). It tracks the performance of stocks in Europe, the Pacific region, and emerging-market countries (among its top holdings is British oil giant BP (NYSE: BP) ). It's cheap, with no load and a 0.32% expense ratio, and its 10-year annualized return beats the S&P 500's by nearly three percentage points.

That's just a starting point -- the allocations will depend on, and change with, your age and years from retirement. The closer you get, the more conservative your portfolio must be (as you switch from building to preserving your nest egg).

The two important factors:

If available, contribute to your 401(k) to the maximum your company will match.

Diversify your investments to maximize your savings.

The Foolish bottom line
The best time to start saving for retirement is yesterday. The second best time is now.

If you need ideas, tools, model portfolios, or specific stock or fund recommendations, I encourage you to let Robert's Rule Your Retirement service guide you through planning for future expenses, asset allocation, strategies for deferring taxes, and more. You can try the service free of charge for 30 days, and you'll have free rein of everything we've ever published with no obligation to subscribe. Click here for all the details.

This article was originally published Sept. 19, 2007. It has been updated.

Claire Stephanic does not own any of the stocks mentioned. Pacific Sunwear is a Stock Advisor recommendation. Panera is Pay Dirt recommendation. The Fool has a disclosure policy.

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